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Previous chapters have described how volatility and correlation forecasts may be generated

using different models. In some cases there are very noticeable differences between the

various forecasts of the same underlying volatility or correlation, and in some cases there are

great similarities. It is a generic problem with volatility forecasting that rather different results

may be obtained, depending on the model used and on the market conditions. Correlation

forecasting is even more problematic because the inherent instability of some correlations

compounds the difficulties.

Even if only one particular type of model were always used, the forecasts will depend on the

parameters chosen. For example, in Figure 3.6 the exponentially weighted moving average

volatility of the CAC at the end of 1997 could be 30% or 45% depending on whether the

smoothing constant is chosen to be 0.96 or 0.84. Many other such examples have been

encountered in previous chapters, such as the different ‘historic’ forecasts of the rand 1-year

swap rate volatilities in Figure 3.2. There are also differences between various types of

GARCH correlation estimates, as shown in Figure 4.13.

The underlying market conditions will also affect results. When markets are stable, in that

they appear to be bounded above and below or that they are trending with a relatively stable

realized volatility, differences between the various forecasts are relatively small. It is

following extreme market events that differences between forecasts tend to be greatest.

If one decides to approach the difficult problem of forecast evaluation, the first consideration

is: which volatility is being forecast? For option pricing, portfolio optimization and risk

management one needs a forecast of the volatility that governs the underlying price process

until some future risk horizon. A geometric Brownian motion has constant volatility, so a

forecast of the process volatility will be a constant whatever the risk horizon. Future volatility

is an extremely difficult thing to forecast because the actual realization of the future process

volatility will be influenced by events that happen in the future. If there is a large market

movement at any time before the risk horizon but after t = 0, the forecast that is made at t = 0

will need to take this into account. Process volatility is not the only interesting volatility to

forecast. In some cases one might wish to forecast implied volatilities, for example in short-

term volatility trades with positions such as straddles and butterflies (Fitzgerald, 1996).

The second consideration is the choice of a benchmark forecast. The benchmark volatility

forecast could be anything, implied volatility or a long-term equally weighted average

statistical volatility being the most common. If a sophisticated and technical model, such as

GARCH, cannot forecast better than the implied or ‘historical’ forecasts that are readily

available from data suppliers (and very easily computed from the raw market data) then it

may not be worth the time and expense for development and implementation.

A third consideration is, which type of volatility should be used for the forecast? Since both

implied and statistical volatilities are forecasts of the same thing, either could be used. Thus a

model could forecast implied volatility with either implied volatility or statistical volatility.

Price process volatilities could be forecast by statistical or implied volatilities, or indeed both

(some GARCH models use implied volatility in the conditional variance equation). There is

much to be said for developing models that use a combination of several volatility forecasts.

When a number of independent forecasts of the same time series are available it is possible to

pool them into a combined forecast that always predicts at least as well as any single

component of that forecast (Granger and Ramanathan, 1984; Diebold and Lopez, 1996). The

Granger–Ramanathan procedure will be described in §5.2.3; the focus of that discussion will

be the generation of confidence intervals for volatility forecasts.

Market Models: Chapter 5

This chapter begins by outlining some standard measures of the accuracy of volatility and

correlation forecasts. Statistical criteria, which are based on diagnostics such as root mean

square forecasting error, out-of-sample likelihoods, or the correlation between forecasts and

squared returns, are discussed in §5.1.1. Operational evaluation methods are more subjective

because they depend on a trading or a risk management performance measure that is derived

from the particular use of the forecast; these are reviewed in §5.1.2.

Any estimator of a parameter of the current or future return distribution has a distribution

itself. A point forecast of volatility is just the expectation of the distribution of the volatility

estimator,1 but in addition to this expectation one might also estimate the standard deviation

of the distribution of the estimator, that is, the standard error of the volatility forecast. The

standard error determines the width of a confidence interval for the forecast and indicates how

reliable a forecast is considered to be. The wider the confidence interval, the more uncertainty

there is in the forecast.2 Standard errors and confidence intervals for some standard

forecasting models are described in §5.2.

Having quantified the degree of uncertainty in a forecast, one should make an adjustment to

the mark-to-market value of an option portfolio when some options have to be marked to

model. The scale of this adjustment will of course depend on the size of the standard error of

the volatility forecast, and in §5.3.1 it is shown that the model price of out-of-the-money

options should normally be increased to account for uncertainty in volatility. Section 5.3.2

shows how uncertainty in volatility is carried through to uncertainty in the value of a

dynamically delta hedged portfolio. It answers the question: how much does it matter if the

implied volatility that is used for hedging is not an accurate representation of the volatility of

the underlying process?

How can it be that so many different results are obtained when attempting to forecast

volatility and correlation using the same basic data? Unlike prices, volatility and correlation

are unobservable. They are parameters of the data generation processes that govern returns.

Volatility is a measure of the dispersion of a return distribution. It does not affect the shape of

the distribution but it still governs how much of the weight in the distribution is around the

centre, and at the same time how much weight is around the extreme values of returns. Small

volatilities give more weight in the centre than large volatilities, so it may be that some

volatility models give better forecasts of the central values, while other volatility models give

better forecasts of the extreme values of returns.

In financial markets the volatility of return distributions can change considerably over time,

but there is only one point against which to measure the success of a fixed horizon forecast:

the observed return over that horizon. The results of a forecast evaluation will therefore

depend on the data period chosen for the assessment. Furthermore, the assessment of

forecasting accuracy will depend very much on the method of evaluation employed (Diebold

and Mariano, 1995). Although we may come across statements such as ‘We employ

fractionally integrated EWMA volatilities because they are more accurate’, it is unlikely that

1 Similarly, a point forecast of correlation is just the expectation of the distribution of the correlation

estimator.

2 Classical statistics gives the expected value of the estimator (point estimate) and the width of the

distribution of the estimator (confidence interval) given some true value of the underlying parameter. It

is a good approximation for the distribution of the true underlying parameter only when the statistical

information (the sample likelihood) is overwhelming compared to one’s prior beliefs. This is not

necessarily so for volatility forecasts, especially for the long term (§8.3.3).

Market Models: Chapter 5

a given forecasting model would be ‘more accurate’ according to all possible statistical and

operational evaluation criteria. A forecasting model may perform well according to some

evaluation criterion but not so well according to others. In short, no definitive answer can ever

be given to the question ‘which method is more accurate?’.

Much research has been published on the accuracy of different volatility forecasts for

financial markets: see, for example, Andersen and Bollerslev (1998) Alexander and Leigh

(1997), Brailsford and Faff (1996), Cumby et al.(1993), Dimson and Marsh (1990), Figlewski

(1997), Frennberg and Hansson (1996), and West and Cho (1995). Given the remarks just

made about the difficulties of this task it should come as no surprise that the results are

inconclusive. However, there is one finding that seems to be common to much of this

research, and that is that ‘historical’ volatility is just about the worst predictor of a constant

volatility process. Considering Figure 5.1, this is really not surprising.3 A realization of a

constant volatility process is just a lag of historical volatility,4 and trying to predict the lag of

a time series by its current value will not usually give good results!

25

20

15

10

0

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

HIST30 REAL30

Some operational and statistical criteria for evaluating the success of a volatility and/or

correlation forecast are described below. Whatever criterion is used to validate the model it

should be emphasized that, however well a model fits in-sample (i.e. within the data period

used to estimate the model parameters), the real test of its forecasting power is in out-of-

sample, and usually post-sample, predictive tests. As explained in §A.5.2, a certain amount of

the historic data should be withheld from the period used to estimate the model, so that the

forecasts may be evaluated by comparing them to the out-of-sample data.

3 Let t = T be the forecast horizon and t = 0 the point at which the forecast is made. Suppose an

exceptional return occurs at time T − 1. The realized volatility of the constant volatility process will

already reflect this exceptional return at time t = 0; it jumps up T periods before the event. However,

the historical volatility only reflects this exceptional return at time T; it jumps up at the same time as

the realized volatility jumps down.

4 This is the case if the historical method uses an equally weighted average of past squared returns over

a look-back period that is the same length as the forecast horizon. More commonly, historical

volatilities over a very long-term average are used to forecast for a shorter horizon – for example, 5-

year averages are used to forecast 1-year average volatilities.

Market Models: Chapter 5

predictions, denoted σ̂ t + 1, … , σ̂ t + T Assume, just to make the exposition easier, that these

forecasts are of 1-day volatilities, so the forecasts are of the 1-day volatility tomorrow, and

the 1-day forward volatility on the next day, and so on until T days ahead. We might equally

well have assumed the forecasts were of 1-month volatility over the next month, 1 month

ahead, 2 months ahead, and so on until the 1-month forward volatility in T months’ time. Or

we might be concerned with intra-day frequencies, such as volatility over the next hour. The

unit of time does not matter for the description of the tests. All that matters is that these

forecasts be compared with observations on market returns of the same frequency.5

A process volatility is never observed; even ex post we can only ever know an estimate, the

realization of the process volatility that actually occurred. The only observation is on the

market return. A 1-day volatility forecast is the standard deviation of the 1-day return, so a 1-

day forecast should be compared with the relevant 1-day return. One common statistical

measure of accuracy for a volatility forecast is the likelihood of the return, given the volatility

forecast. That is, the value of the probability density at that point, as explained in §A.6.1.

Figure 5.2 shows that the observed return r has a higher likelihood under f(x) than under g(x).

That is, r is more likely under the density that is generated by the volatility forecast that is the

higher of the two. One can conclude that the higher volatility forecast was more accurate on

the day that the return r was observed.

0.22

0.2

0.18

0.16

0.14

0.12

0.1

0.08

0.06

0.04

0.02

0

f(x) g(x)

Suppose that we want to compare the accuracy of two different volatility forecasting models,

A and B.6 Suppose model A generates a sequence of volatility forecasts, { σ̂ t + 1, … , σ̂ t + T}A

and model B generates a sequence of volatility forecasts, { σ̂ t + 1, …….., σ̂ t + T}B. For model

A, compare each forecast σ̂ t + j with the observed return on that day, rt + j , by recording the

likelihood of the return as depicted in Figure 5.2. The out-of-sample likelihood of the whole

sequence of forecasts is the product of all the individual likelihoods, and we can denote this

LA. Similarly, we can calculate the likelihood of the sample given the forecasts made with

model B, LB. If over several such post-sample predictive tests, model A consistently gives

higher likelihoods than model B, we can say that model A performs better than model B.

5 If implied volatility is being forecast, then the market implied volatility is the observed quantity that

can be used to assess the accuracy of forecasts.

6 These could be two EWMA models, but with different smoothing constants; or a 30-day and a 60-day

historic model; or an EWMA and a GARCH; or two different types of GARCH; or a historic and an

EWMA, etc.

Market Models: Chapter 5

Different volatility forecasting models may be ranked by the value of the out-of-sample

likelihood, but the effectiveness of this method does rely on the correct specification of the

return distributions. Generally speaking, we assume that these return distributions are normal,

but if they are not normal then the results of out-of-sample likelihood tests will not be

reliable. If likelihood criteria are to be used it is advisable to accompany results with a test for

the assumed distribution of returns (§10.1).

Much of the literature on volatility forecasting uses a root mean square error (RMSE)

criterion instead of a likelihood (§A.5.3). But while a RMSE may be fine for assessing price

forecasts, or any forecasts that are of the mean parameter, there are problems with using the

RMSE criterion for volatility forecasting (Makridakis, 1993). In fact, the ‘minimize the

RMSE’ criterion is equivalent to the ‘maximize the likelihood’ criterion when the likelihood

function is normal with a constant volatility.7 Hence RMSEs are applicable to mean

predictions, such as those from a regression model, rather than variance or covariance

predictions.8

Not only is the RMSE criterion applicable to means rather than variances, one statistical

performance measure that has, unfortunately, slipped into common use is an RMSE between a

volatility forecast and the realized volatility, which is just one observation on the process

volatility. As a statistical criterion this makes no sense at all, because the correct test is an F-

test, not an RMSE. 9 In fact the only justification for using the RMSE between a forecast and

the ex-post realized volatility is that it is a simple distance metric.

accuracy is to use the RMSE to compare the forecast of variance with the appropriate squared

return. The difference between the variance forecast and the squared return is taken as the

forecast error. These errors are squared and summed over a long post-sample period, and then

square-rooted to give the post-sample RMSE between the variance forecast and the squared

returns. However, these RMSE tests will normally give poor results, because although the

expectation of the squared return is the variance, there is a very large standard error around

this expectation. That is, the squared returns will jump about excessively while the variance

forecasts remain more stable. The reason for this is that the return rt is equal to σtzt, where zt is

a standard normal variate, so the squared return yields very noisy measurements due to

excessive variation in zt2.

Another popular statistical procedure is to perform a regression of the squared returns on the

variance forecast. If the variance is correctly specified the constant from this regression

should be zero and the slope coefficient should be one. But since the values for the

explanatory variable are only estimates, the standard errors-in-variables problem of regression

described in §A.4.2 produces a downward bias on the estimate of the slope coefficient.

7 To see this, suppose returns are normal so (from §A.6.3) the likelihood L is most easily expressed as:

−2lnL = nln(2π) + nlnσ2 + Σ(xi − µ)2/σ2.

Now maximizing L is equivalent to minimizing −2lnL, and when volatility is constant this is equivalent

to minimizing Σ(xi − µ)2. This is the same as minimizing √(Σ(xi − µ)2), that is, the root of the sum of the

squared errors between forecasts xi and the mean.

8 Of course, a variance is a mean, but the mean of the squared random variable, which is chi-squared

distributed, not normally distributed, so the likelihood function is totally different and does not involve

any sum of squared errors.

9 Hypothesis tests of the form H : σ = σ would be relevant; that is, to test whether the process

0 Α B

volatility underlying the forecast is the same as the process volatility that generated the realization we

have observed, ex post. Therefore an F-test based on the test statistic σ̂ / σ̂ 2 B for the equality of

2

A

two variances would apply.

Market Models: Chapter 5

The R2 from this regression will assess the amount of variation in squared returns that is

explained by the successive forecasts of σ2. However, the excessive variation in squared

returns that was mentioned above also presents problems for the R2 metric. In fact this R2 will

be bounded above, and the bound will depend on the data generation process for returns. For

example, Andersen and Bollerslev (1998) show that if returns are generated by the symmetric

GARCH(1,1) model (4.2), then the true R2 from a regression of the squared returns on the

variance forecast will be

R2 = α2 / (1 − β2 − 2αβ). (5.1)

0.05 0.85 0.0130 0.075 0.83 0.0301 0.1 0.8 0.0500

0.05 0.86 0.0143 0.075 0.84 0.0334 0.1 0.81 0.0550

0.05 0.87 0.0160 0.075 0.85 0.0375 0.1 0.82 0.0611

0.05 0.88 0.0182 0.075 0.86 0.0428 0.1 0.83 0.0689

0.05 0.89 0.0210 0.075 0.87 0.0500 0.1 0.84 0.0791

0.05 0.9 0.0250 0.075 0.88 0.0601 0.1 0.85 0.0930

0.05 0.91 0.0309 0.075 0.89 0.0756 0.1 0.86 0.1131

0.05 0.92 0.0406 0.075 0.9 0.1023 0.1 0.87 0.1447

0.05 0.93 0.0594 0.075 0.91 0.1589 0.1 0.88 0.2016

0.05 0.94 0.1116 0.075 0.92 0.3606 0.1 0.89 0.3344

Relation (5.1) provides an upper bound for the R2 for GARCH(1,1) forecasts, and similar

upper bounds apply to other standard forecasting models. Table 5.1 shows how the true R2

varies with some common values for the estimates of α and β. Most of the R2 are extremely

small, and the largest value in the table is around 1/3, nothing like the maximum value of 1

that one normally expects with R2. Therefore it is not surprising that most of the R2 that are

reported in the literature are less than 0.05. Earlier conclusions from this literature, that

standard volatility models have very poor forecasting properties, should be reviewed in the

light of this finding. The fact that the R2 from a regression of squared returns on the forecasts

of the variance is low does not mean that the model is misspecified.

An operational evaluation of volatility and correlation forecasts will focus on the particular

application of the forecast. Thus any conclusions that may be drawn from an operational

evaluation will be much more subjective than those drawn from the statistical methods just

described. The advantage of using an operational criterion is that the volatility forecast is

being assessed in the actual context in which it will be used. The disadvantage of operational

evaluation is that the results might imply the use of a different type of forecast for every

different purpose.

Some operational evaluation methods are based on the P&L generated by a trading strategy.

A measurement of trading performance is described in §A.5.3 that is relevant for price

forecasting, where an underlying asset is bought or sold depending on the level of the price

forecast. A performance criterion for volatility or correlation forecasts should be based on

hedging performance (Engle and Rosenberg, 1995) or on trading a volatility- or correlation-

dependent product.

For example, the metric for assessing a forecast of implied volatility could involve buying or

selling straddles (a put and a call of the same strike) depending on the level of the volatility

Market Models: Chapter 5

that is forecast. Straddles have a V-shaped pay-off and so will be in-the-money if the market

is volatile, that is, for a large upward or downward movement in the underlying. The forecast

of volatility σ̂ can be compared with the current implied volatility level σ, and then a trading

strategy can be defined that depends on their difference.

The choice of strategy is an entirely subjective decision. It depends on how one proposes to

implement the trades. For example, a simple trading strategy for an implied volatility forecast

σ̂ that relates to a single threshold implied volatility τ, might be: ‘buy one at-the-money

straddle if σ̂ − σ > τ ; otherwise do nothing’. An alternative volatility strategy could be: ‘buy

one ATM straddle if σ̂ − σ > τ1; sell one ATM straddle if σ̂ − σ < τ2 ; otherwise do nothing’.

Or the strategy may go long or short several straddles, depending on various thresholds: ‘buy

n1 straddles if σ̂ − σ ≥ τ1; sell n2 straddles if σ̂ − σ ≤ τ2; otherwise do nothing’.

The P&L results from this strategy will depend on many choices: the number of trades n1 and

n2, the thresholds τ1 and τ2 , the frequency of trades, the strike of the straddles and, of course,

the underlying market conditions during the test, including the current level of implied

volatility σ. Clearly an evaluation strategy that is closest to the proposed trading strategy

needs to be designed and the trader should be aware that the optimal forecasting model may

very much depend on the design of the evaluation strategy.

When volatility and correlation forecasts are used for risk management the operational

evaluation of volatility and correlation forecasts can be based on a standard risk measure such

as Value-at-Risk. The general framework for backtesting of VaR models will be discussed in

§9.5. But if the model performs poorly it may be for several reasons, such as non-normality in

return distributions, and not just the inaccuracy of the volatility and correlation forecasts.

Alexander and Leigh (1997) perform a statistical evaluation of the three types of statistical

volatility forecasts that are in standard use: ‘historical’ (equally weighted moving averages),

EWMAs and GARCH. Given the remarks just made, it is impossible to draw any firm

conclusions about the relative effectiveness of any volatility forecasting method for an

arbitrary portfolio. However, using data from the major equity indices and foreign exchange

rates, some broad conclusions do appear. While EWMA methods perform well for predicting

the centre of a normal distribution, the VaR model backtests indicate that GARCH and

equally weighted moving average methods are more accurate for the tails prediction required

by VaR models. These results seem relatively independent of the data period used.

GARCH forecasts are designed to capture the fat tails in return distributions, so VaR

measures from GARCH models tend to be larger than those that assume normality. The

‘ghost features’ of equally weighted averages that follow exceptional market moves have a

similar effect on the ‘historical’ VaR measures. Therefore it is to be expected that these two

types of forecasts generate larger VaR measures for most data periods, and consequently

better VaR backtesting results (§9.5.1).

We have examined the ability of point forecasts of volatility to capture the constant volatility

of a price process. These point forecasts are the expectation of the future volatility estimator

distribution. Another important quality for volatility forecasts is that they have low standard

errors. That is, there is relatively little uncertainty surrounding the forecast or, to put it

another way, one has a high degree of confidence that the forecast is close to the true process

volatility. In §A.5.1 it is shown how standard errors of statistical regression forecasts are used

to generate confidence intervals for the true value of the underlying parameter. These

Market Models: Chapter 5

principles may also be applied to create confidence intervals for the true volatility, or for the

true variance if that is the underlying parameter of interest.

The statistical models described in chapters 3 and 4 are variance forecasting models.10 When

the variance is forecast, the standard error of the forecast refers to the variance rather than to

the volatility. Of course, the standard error of the volatility forecast is not the square root of

the standard error of the variance forecast, but there is a simple transformation between the

two. Since volatility is the square root of the variance, the density function of volatility is

where h(σ2) is the density function of variance.11 Relationship (5.2) may be used to transform

results about predictions of variances to predictions of volatility.

A confidence interval for the variance σ̂ 2 estimated by an equally weighted average may be

obtained by a straightforward application of sampling theory. If a variance estimate is based

on n normally distributed returns with an assumed mean of zero, then n σ̂ 2 / σ2 has a chi-

squared distribution with n degrees of freedom.12 A 100(1 − α)% two-sided confidence

interval for n σ̂ 2 / σ2 would therefore take the form (χ2n, 1 − α/2, χ2n, α/2) and a straightforward

calculation gives the associated confidence interval for the variance σ2 as:

For example a 95% confidence interval for an equally weighted variance forecast based on 30

observations is obtained using the upper and lower chi-squared critical values:

So the confidence interval is (0.6386 σ̂ 2, 1.7867 σ̂ 2) and exact values are obtained by

substituting in the value of the variance estimate.

Assuming normality,13 the standard error of an equally weighted average variance estimator

based on n (zero mean) squared returns is [√(2/n)]σ2. Therefore, as a percentage of the

variance, the standard error of the variance estimator is 20% when 50 observations are used in

the estimate, and 10% when 200 observations are used in the estimate.

10The volatility forecast is taken to be the square root of the variance forecast, even though E(σ) ≠

√E(σ2).

11 If y is a (monotonic and differentiable) function of x then their probability densities g(·) and h(·) are

related by g(y) = dx/dyh(x). So if y = √x, dx/dy= 2y.

12 The usual degrees-of-freedom correction does not apply since we have assumed throughout that

returns have zero mean.

13 It follows from footnote 9 that if X are independent random variables (i = 1, … , n) then f(X ) are

i i

also independent for any monotonic differentiable function f(·). Moving average models already

assume that returns are i.i.d. Now

n

assuming normality too, so that the returns are NID(0, σn 2), we apply

the variance operator to σˆ t = ∑ rt −i / n . Since the squared returns are independent V (σˆ 2t ) = ∑ V ( rt2− i ) / n 2 .

2 2

i =1 i =1

4 4 4

Now V(rt ) = E(rt ) − [E(rt )] = 3σ − σ = 2σ by normality, and it follows that the variance of the

2 4 2 2

Market Models: Chapter 5

(1 − λ ) 4

2 σ .

(1 + λ )

Therefore, as a percentage of the variance, the standard error of the EWMA variance

estimator is about 5% when λ = 0.95, 10.5% when λ = 0.9, and 16.2% when λ = 0.85.

To obtain error bounds for the corresponding volatility estimates, it is of course not

appropriate to take the square root of the error bounds for the variance estimate. However, it

can be shown that15

V( σ̂ 2) ≈ (2σ)2 V( σ̂ ).

The standard error of the volatility estimator (as a percentage of volatility) is therefore

approximately one-half the size of the variance standard error (as a percentage of the

variance).16 As a percentage of the volatility, the standard error of the equally weighted

volatility estimator is approximately 10% when 50 observations are used in the estimate, and

5% when 200 observations are used in the estimate; the standard error of the EWMA

volatility estimator is about 2.5% when λ = 0.95, 5.3% when λ = 0.9, and 8.1% when

λ = 0.85.

The standard errors on equally weighted moving average volatility estimates become very

large when only a few observations are used. This is one reason why it is advisable to use a

long averaging period in ‘historical’ volatility estimates. On the other hand, the longer the

averaging period, the longer-lasting the ‘ghost effects’ from exceptional returns (see Figure

3.1).

The covariance matrix of the parameter estimates in a GARCH model can be used to generate

GARCH confidence intervals for conditional variance. For example, the variance of the one-

step-ahead variance forecast in a GARCH(1,1) model is

ˆ t2+1 ) = Vt ( ω

Vt ( σ ˆ )ε t4 + Vt ( β

ˆ ) + Vt ( α ˆ t4

ˆ )σ

(5.4)

+ 2 covt ( ω ˆ ) ε t2 + 2 covt ( ω

ˆ ,α ˆ ,β

ˆ )σˆ t2 + 2 covt ( α ˆ )ε 2 σ

ˆ ,β ˆ2

t t

The estimated covariance matrix of parameter estimates is part of the standard output in

GARCH procedures. It will depend on the sample size used to estimate the model: as with the

error bounds for moving average estimates given above, the smaller the sample size the

bigger these quantities. However, in the GARCH forecast by far the largest source of

uncertainty is the unexpected return at time t. If there is a large an unexpected movement in

Applying the variance operator to (3.3): V( σ̂ ) = [(1 − λ)2/(1 − λ2)] V(rt − 12) = [(1 − λ)/(1 + λ)] 2σ4.

14 2

15 Taking a second-order Taylor expansion of f(x) about µ, the mean of X, and taking expectations

gives E(f(X)) ≈ f(µ) + ½V(X) f´´(µ). Similarly, E(f(X)2) ≈ f(µ)2 + V(X)[ f´(µ)2 − f(µ)f´´(µ)], again

ignoring higher-order terms. Thus V(f(X)) ≈ f´(µ)2V(X).

16 For the equally weighted average of length n, the variance of the volatility estimator is

(2σ4/n)(1/2σ)2 = σ2/(2n), so the standard error of the volatility estimator as a percentage of volatility is

1/√(2n); For the EWMA, the variance of the volatility estimator is (2[(1 − λ)/(1+λ)]σ4)(1/2σ)2 = [(1 −

λ)/(1+λ)]σ2/2, so the standard error of the volatility estimator as a percentage of volatility is √[(1-

λ)/2(1+λ)].

Market Models: Chapter 5

the market, in either direction, then εt2 will be large and the effect in (5.4) will be to widen the

confidence interval for the GARCH variance considerably.

Consider the GARCH(1,1) models discussed in §4.3.2. Table 5.2 reports upper and lower

bounds for 95% confidence intervals for the 1-day-ahead GARCH variance forecasts that are

generated using (4.16) with a number of different values for unexpected daily return. The

confidence interval for the variance is quoted in annualized terms assuming 250 days a year.

Note that these returns will be squared in the symmetric GARCH(1,1), so it does not matter

whether they are positive or negative.

Table 5.2: GARCH variance 95% confidence interval bounds on 11 September 1998

Return Lower Upper Lower Upper Lower Upper

0.001 0.10080 0.10345 0.20367 0.20649 0.13829 0.14022

0.002 0.099647 0.10460 0.20273 0.20742 0.13722 0.14130

0.003 0.098144 0.10610 0.20144 0.20871 0.13606 0.14245

0.004 0.096568 0.10768 0.20006 0.21009 0.13489 0.14362

0.005 0.094967 0.10928 0.19865 0.21151 0.13371 0.14480

Note that the GARCH confidence intervals are much wider following a large unexpected

return − rather than uncertainty in parameter estimates, it is market behaviour that is the main

source of uncertainty in GARCH forecasts. These confidence intervals are for the variance,

not the volatility, but may be translated into confidence intervals for volatility.17 For example,

the confidence intervals for an unexpected return of 0.005 translate into a confidence interval

in volatility terms of (30.8%, 33.1%) for the S&P 500, (44.6%, 46%) for the CAC and

(36.5%, 37.9%) for the Nikkei 225.

Suppose a process volatility σ is being forecast and that there are m different forecasting

models available.18 Denote the forecasts from these models by σ̂ 1, σ̂ 2, … , σ̂ m and suppose

that each of these forecasts has been made over a data period from t = 0 to t = T. Now suppose

we have observed, ex-post, a realization of the process volatility over the same period. The

combined forecasting produce of Granger and Ramanathan (1984) applied in this context

requires a least squares regression of the realized volatility σ on a constant and σ̂ 1, σ̂ 2, … ,

σ̂ m . The fitted value from this regression is a combined volatility forecast that will fit at least

as well as any of the component forecasts: the R2 between realized volatility and the

combined volatility forecast will be at least as big as the R2 between realized volatility and

any of the individual forecasts. The estimated coefficients in this regression, after

normalization so that they sum to one, will be the optimal weights to use in the combined

forecast.

Figure 5.3 shows several different forecasts of US dollar exchange rate volatilities for

sterling, the Deutschmark and the Japanese yen. Some general observations on these figures

are as follows:

• The GARCH forecasts seem closer to the implied volatilities.

17Percentiles are invariant under monotonic differentiable transformations, so the confidence limits for

volatility are the square root of the limits for variance.

Market Models: Chapter 5

• The historic 30-day and the EWMA forecasts with λ = 0.94 are similar (because the half-

life of an EWMA with λ = 0.94 is about 30 days).

• The EWMA 90-day forecasts are out of line with the other 90-day forecasts (because the

EWMA model assumes a constant volatility, the 90-day forecasts are the same as the 30-

day forecasts).

• There is more agreement between the different 30-day forecasts than there is between the

different 90-day forecasts (because uncertainties increase with the risk horizon).

• The volatility forecasts differ most at times of great uncertainty in the markets, for

example during 1994 in sterling and during 1990 in the Deutschmark. On the other hand,

they can be very similar when nothing unusual is expected to happen in the market, for

example during 1990 in the yen.

Figure 5.3a: 30-day Volatility Forecasts Figure 5.3d: 90-day Volatility Forecasts

GBP-USD DEM-USD

25

25

20 20

15 15

10 10

5 5

0 0

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95 May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

Figure 5.3b: 90-day Volatility Forecasts Figure 5.3e : 30-day Volatility Forecasts

GBP-USD JPY-USD

25 25

20 20

15 15

10 10

5 5

0 0

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95 May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

Figure 5.3c: 30-day Volatility Forecasts Figure 5.3f: 90-day Volatility Forecasts

DEM-USD JPY-USD

25

25

20

20

15

15

10

10

5

5

0

0

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

GARCH90 EWMA HIST90 IMP90

GARCH30 EWMA HIST30 IMP30

Market Models: Chapter 5

Now suppose that a combination of these forecasts is to be used as a single forecast for

realized volatility. Table 5.3 summarizes the results of the ordinary least squares regressions

of realized volatility on the GARCH, historic, EWMA and implied volatility forecasts shown

in Figure 5.3. Some general conclusions may be drawn from the estimated coefficients and

the t-statistics (shown in parentheses). Firstly, the GARCH forecasts take the largest weight in

the combined forecast, although they are not always the most significant. In fact implied

volatilities are often very significant, particularly for the 30-day realized volatilities. Historic

and EWMA forecasts have low weights, in fact they are often less than zero, so they appear to

be negatively correlated with realized volatility.19 In each case the fitted series gives the

optimal combined forecast for realized volatility. Note that the intercept is quite large and

negative in most cases, which indicates that the forecasts have a tendency to overestimate

realized volatility.

30-day 90-day 30-day 90-day 30-day 90-day

Intercept −2.02 0.44 −3.73 −3.06 −6.08 −4.67

(−2.78) (0.35) (−3.83) (−1.41) (−6.23) (−2.09)

GARCH 1.13 1.02 1.16 1.48 1.56 1.49

(6.58) (5.12) (8.33) (6.52) (10.36) (5.94)

Historic −0.26 0.19 −0.10 0.11 0.24 −0.24

(−3.56) (4.48) (−1.36) (2.97) (3.36) (−5.90)

EWMA −0.24 −0.14 −0.27 −0.03 −0.81 −0.10

(λ = 0.94) (−1.77) (−1.45) (−2.35) (−0.59) (−7.19) (−1.57)

Implied 0.50 −0.12 0.51 −0.27 0.54 0.26

(8.32) (−1.6) (9.21) (−4.3) (11.2) (5.00)

Est s.e. 2.87 2.47 2.83 2.22 2.65 2.20

R2 0.56 0.46 0.47 0.3 0.51 0.34

Figure 5.4a shows two combined forecasts of 30-day realized volatility of the GBP–USD rate.

Forecast 1 uses all four forecasts as in Table 5.3, and forecast 2 excludes the EWMA forecast

because of the high multicollinearity with the historic 30-day forecast (§A.4.1). In each case

the model was fitted up to April 1995 and the last 6 months of data are used to compare the

model predictions with the realized volatility out-of-sample in Figure 5.4b. Since the 30-day

realized volatility jumps up 30 days before a large market movement, it is a very difficult

thing to predict, particularly when markets are jumpy. There is, however, a reasonable

agreement between the forecast and the realized volatility during less volatile times, and the

out-of-sample period marked with a dotted line on the figures happened to be relatively

uneventful.

The 90-day realized volatility jumps up 90 days before a large market movement, so it is even

more difficult to predict. Not surprisingly the models in Table 5.3 have much lower R2 for 90-

day realized volatility in all three rates. Figure 5.4c shows the combined forecast from the

GBP–USD model in the second column of Table 5.3, and much of the time it performs rather

poorly.

19 The low and insignificant coefficients on the historic 30-day forecast and the EWMA are a result of

a high degree of multicollinearity of these variables (§A.4.1). In fact their unconditional correlation

estimate during the sample is over 0.95 in all three models. When there is a high level of correlation

between some explanatory variables the standard errors on coefficient estimators will be depressed, and

the danger is that the model will be incorrectly specified. However, multicollinearity does not affect

forecasts so it does no real harm to the combined forecast if both 30-day historic and EWMA forecasts

are in the model.

Market Models: Chapter 5

of GBP-USD

25

20

15

10

0

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

Combined Forecast

11

10

4

26-Apr-95 9-May-95 19-May-95 1-Jun-95 13-Jun-95 23-Jun-95 5-Jul-95

Forecast of GBP-USD

20

15

10

5

May-88 May-89 May-90 May-91 May-92 May-93 May-94 May-95

The lack of precision of these models is reflected by confidence intervals for realized

volatility which turn out to be rather wide, because of the large standard error in the models.

The linear regression approach to the construction of combined volatility forecasts allows one

to use standard results on confidence intervals for regression predictions (Appendix A.5.1) to

construct confidence intervals for volatility forecasts. For example, a two-sided confidence

interval for the realized volatility will be

Market Models: Chapter 5

ξt = Zαs√( 1 + Rt(X´X)−1Rt),

where Zα is an appropriate critical value (in this case normal since very many points were

used for the regression), s is the estimated standard error of the regression, X is the matrix of

in-sample data on the different volatility forecasts and Rt = (1, σ̂ 1t, σ̂ 2t, … , σ̂ mt)´ the vector

of the individual volatility forecasts at the time when the combined forecast is made.

As an example, return to the realized volatility forecasts shown Figure 5.3. The X matrix for

the GBP 30-day realized ‘combined forecast 2’ in figure 5.4a contains data on 1s (for the

constant), 30-day GARCH volatility, 30-day historic and 30-day implied, and

(X´X)−1 = − 0 .00543 0 .00115 − 0 . 0066 0 .00001 .

0 . 00274 − 0 .0066 0 .00042 − 0 . 00021

− 0 .00110 − 0 . 00021 0 .00011

0 .00001

The vector Rt depends on the time period. For example, on 7 July 1995 it took the value (1,

9.36, 9.55, 8.7)´ and so Rt(X´X)−1Rt = 0.0023. Since the estimated in-sample standard error of

regression was s = 2.936, and the 5% critical value of N(0,1) is 1.645, the value ξt, for a 90%

confidence interval based on (5.5) for the true realized volatility on 7 July 1995 was 4.83. The

point prediction of realized volatility on that day was 8.44, so the interval prediction is 8.44 ±

4.83. Therefore from this model one can be 90% sure that realized volatility would be

between 3.61% and 13.27%. Similarly, a 95% confidence interval is (2.68%, 14.2%). These

interval predictions are very imprecise. Similar calculations for the other rates and for 90-day

volatilities shows that all interval predictions are rather wide. This is because the standard

errors of regression are relatively large and the ‘goodness’ of fit in the models is not

particularly good.

Volatility is very difficult to predict − and correlation perhaps even more so. This section

considers how one should account for the uncertainty in volatility and correlation when

valuing portfolios. When portfolios of financial assets are valued, they are generally marked-

to-market. That is, a current market price for each option in the portfolio is used to value the

portfolio. However, there may not be any liquid market for some assets in the portfolio, such

as OTC options. These must be valued according to a model, that is, they must be marked-to-

model (MtM). Thus the MtM value of a portfolio often contains marked-to-model values as

well as marked-to-market values.

There are uncertainties in many model parameters; volatility and correlation are particularly

uncertain. When uncertainty in volatility (or correlation) is captured by a distribution of the

volatility (or correlation) estimator; this distribution will result in a distribution of mark-to-

model values. In this section the MtM value of an options portfolio is regarded as a random

variable. The expectation of its distribution will give a point estimate of MtM value.

However, instead of the usual MtM value, this expectation will be influenced by the

uncertainty in the volatility parameter. The adjustment to the usual value will be greatest for

OTM options; on the other hand, the variance of the adjusted MtM value will be greatest for

ATM options.

Market Models: Chapter 5

We shall show that volatility and correlation uncertainty give rise to a distribution in MtM

values. Distributions of MtM values are nothing new. This is exactly what is calculated in

VaR models. However, in VaR models the value distribution arises from variations in the risk

factors of a portfolio, such as the yield curves, exchange rates or equity market indices. This

section discusses how to approach the problem of generating a value distribution where the

only uncertainty is in the covariance matrix forecast.

In the first instance let us consider how the uncertainty in a volatility forecast can affect the

value of an option. Suppose that the volatility forecast is expressed in terms of a point

prediction and an estimated standard error of this prediction. The point prediction is an

estimate of the mean E(σ) of the volatility forecast, and the square of the estimated standard

error gives an estimate of the variance V(σ) of the volatility forecast. Denote by f(σ) the value

of the option as a function of volatility, and take a second-order Taylor expansion of f(σ)

about E(σ) :

and this can be approximated by putting in the point volatility prediction for E(σ) and the

square of the estimated standard error of that prediction for V(σ).

It is common practice for traders to plug a volatility forecast value into f(σ) and simply read

off the value of the option. But (5.7) shows that when the uncertainty in the volatility forecast

is taken into account, the expected value of the option requires more than just plugging the

point volatility forecast into the option valuation function. The extra term on the right-hand

side of (5.7) depends on ∂2f/∂σ2.20 For the basic options that a usually priced using the Black-

Scholes formula, ∂2f/∂σ2 is generally positive when the option is OTM or ITM, but when the

option is nearly ATM then ∂2f/∂σ2 will be very small (and it may be very slightly negative).

We have already seen that Black–Scholes ‘plug-in’ option prices for OTM and ITM options

are too low and that this is one reason for the smile effect (§2.2.1). The adjustment term in

(5.7) means that when some account is taken of the uncertainty in forecasts of volatility, the

Black–Scholes ‘plug-in’ price will be revised upwards. On the other hand, the Black–Scholes

price of an ATM option will need negligible revision. It may be revised downwards, but only

by a very small amount. We shall return to this problem in §10.3.3, when the volatility

uncertainty will be modelled by a mixture of normal densities. The empirical examples given

there will quantify the adjustment for option prices of different strikes and it will be seen that

simple ATM options will require only very small adjustments, if any, because they are

approximately linear in volatility.

However, the variance of the model value due to uncertain volatility will be greatest for ATM

options. To see this, take variances of (5.7):

20 This is similar to the new Greek ‘psi’ that was introduced by Hull and White (1997) to capture

kurtosis sensitivity in options (§10.3.3).

Market Models: Chapter 5

This shows that the variance of the value is proportional to the variance of the volatility

forecast, and it also increases with the square of the option volatility sensitivity, that is, the

option vega (§2.3.3). Options that are near to ATM will have the largest contribution to the

variance of the option portfolio value due to uncertain volatility, since they have the greatest

volatility sensitivity.

The adjustments that need to be made to the value of a portfolio of options to account for

uncertainty in the correlation forecasts are not easy to express analytically. A simple graphical

method is to plot the value as a function of correlation and examine its convexity in the local

area of the point correlation forecast. Figure 5.5a illustrates a hypothetical value as a function

of correlation. If the correlation forecast is ρ̂1 then the value should be adjusted downwards

for uncertainty in correlation because the function is concave at this point, but if the

correlation forecast is ρ̂ 2 then the value should be adjusted upwards for uncertainty in

correlation because the function is convex at this point. Figure 5.5b shows that the amount of

this adjustment depends on the degree of uncertainty in correlation and the shape of the value

as a function of correlation. If correlation is known to be ρ then the option value is V(ρ).

However, if correlation is unknown, suppose it takes the value ρ1 with probability p and the

value ρ2 with probability 1− p: in this case, because the option value is convex in correlation,

the option value pV(ρ1) + (1 − p)V(ρ2) is greater than V(ρ). Thus the uncertainty in

correlation, in this case, would lead to an upward adjustment in the option value.

Value

ρ1 ρ2 Correlation

Value

pV(ρ1 ) + (1 - p)V(ρ2 )

V(ρ)

ρ1 ρ ρ2

Value

Option 1

Correlation

Option 2

Market Models: Chapter 5

Rather than making an ad-hoc adjustment in portfolio values, it may be preferable to hedge

this correlation risk by taking a position with the opposite characteristics. For example, if

value is a concave function of correlation this portfolio could be hedged with a portfolio that

has a value which is a convex function of correlation, as depicted in Figure 5.5c.

Unfortunately, it is not always possible to find such products in the market, although recently

there has been some growth in the markets for OTC products such as currency correlation

swaps to hedge correlations between two currency pairs.

Before ending this section, it is worthwhile to comment that the method for adjusting

portfolio values due to uncertain correlation that is depicted in Figure 5.5 should be applied to

all parameters in the portfolio pricing model. Volatility is easier, because the adjustments

have a simple analytic form described by (5.7) and (5.8). But for correlation, and all other

parameters, it is worthwhile to investigate the degree to which they affect the value and, if

necessary, make adjustments for uncertainties in parameter estimates.

How much does it matter if there are errors in the implied volatilities that are used to calculate

deltas for dynamic hedging of an option portfolio? It is possible to answer this question with

an empirical analysis, as the following example shows. Consider a short position on a 90-day

call option that is delta hedged daily using an implied volatility of 15%. The process volatility

is unknown, of course, but suppose you believe that it could take any value between 8% and

18% and that each value is equally likely. What is the error in the value of the delta hedged

portfolio?

For a given process volatility we can estimate the value of the option in h days’ time, and so

also the value of the delta hedged portfolio. Using 1000 Monte Carlo simulations on the

underlying price process, with a fixed process volatility, we obtain an expected value for the

option (taking the discounted expected value of the pay-off distribution as described in

§4.4.2) and a measure of uncertainty in this option value (either the standard error of the

option value distribution over 1000 simulations, or the 1% lower percentile of this

distribution21). In each simulation, the evolution of the underlying price and the fixed delta

(corresponding to an implied volatility of 15%) allow us to compute the expected present

value of the delta hedged portfolio, along with a measure of uncertainty (standard error or

percentile). We can do this for each process volatility x% (x = 8, 9, … , 18) and thus generate

a curve that represents the expected value of the hedged portfolio as a function of the process

volatility. Then, taking the time horizons h = 1, 2, …, 90 gives a surface that represents the

expected value of the hedged portfolio as a function of the process volatility x and time

horizon h. For the uncertainty around this surface, the 1% lower percentile of the value

change distribution is a good measure since it corresponds to a the 1% h-day VaR measure.

Figure 5.6 shows the 1% VaR for each possible process volatility between 8% and 18% and

for each holding period from 1 to 90 days. The figure shows that VaR measures can be high

even when process volatility is low, if the option is hedged for a long period using the wrong

hedging volatility. So much is obvious, but what is more interesting is that the VaR measures

are much greater when the process volatility is above 15%. That is, when the (wrong) hedging

volatility of 15% is underestimating the process volatility, some VaR measures can be very

considerable indeed.

There is a simple explanation for the shape of this surface. With continuous rebalancing, the

variance of a delta hedged portfolio due to using the wrong hedging volatility is

approximately (σh − σ0)2 (vega)2, where σh denotes the implied volatility used for hedging and

Market Models: Chapter 5

σ0 denotes the process volatility.22 This is only a local approximation. In fact the standard

error of the hedged portfolio value has the asymmetric shape shown in Figure 5.7.

4

x 10

0

20

15 100

10 50

The standard error of the value of the portfolio (option plus hedge) is zero if σh = σ0. If the

hedging volatility is correct the option can be perfectly hedged. But σ0 is unknown, and if the

implied (hedging) volatility is not equal to the process volatility, the standard error of the

portfolio value increases with the volatility error, as shown in Figure 5.7. It is not symmetric:

if the process volatility is less than the hedging volatility then there is less uncertainty in the

value of the hedged portfolio; if the process volatility is greater than the hedging volatility

then there is more uncertainty in the value of the hedged portfolio. This means that if one

does not know whether the hedging volatility is accurate, it is better to use a higher value than

a lower value. That is, there will be less uncertainty in the value of the hedged portfolio if one

over-hedges the position.

Volatility

s.e. of hedged

portfolio

1.5

0

1 σ0

hedging volatility

22 Discrete rebalancing increases the standard error of the hedged portfolio by a factor that depends on

1/√(2n), where n is the number of rebalancings, and on the process volatility; the standard error curve

still has an asymmetric smile shape.

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